Introduction
Despite decades of progress in many areas, persistent structural weaknesses continue to hamper effective tax collection and public spending, negatively impacting economic growth and development across Latin America and the Caribbean (ALC).
Current Fiscal Situation
Government revenues and expenditures have remained near pre-pandemic averages, leaving ALC countries with limited fiscal space. Efforts to reduce budget deficits, currently averaging 3% of GDP, have largely stalled. Between 2014 and 2024, public debt rose from 45% to 60% of GDP, according to our calculations based on IMF data, pushing interest payments to 2.7% of GDP—approximately the annual investment needed to close the region’s infrastructure gap.
The Need for Fiscal Reform
While some economists argue that drastic austerity measures are needed to overcome these fiscal pressures, we believe there is a more gentle, intelligent, and politically viable path to reverse ALC’s debt trajectory. The key to achieving fiscal sustainability lies in reforming how public funds are collected and allocated.
- Governments face growing pressure to invest in public services and infrastructure but are limited by outdated and ineffective tax tools.
- Current tax systems collect very little revenue and often distort investment and labor market decisions.
- Public spending is frequently inefficient or misdirected, eroding public trust.
- A forthcoming study estimates that wastefulness accounts for 4.6% of ALC’s GDP, slightly higher than a decade ago.
These structural deficiencies not only limit growth but also hinder efforts to reduce inequality, as high levels of informal employment and regressive value-added tax (VAT) contribute to ALC economies being less effective than developed counterparts in using taxes, social spending, and transfers to narrow income disparities. In fact, in six countries, fiscal systems exacerbate poverty.
Political Challenges and Solutions
Deep fiscal reform remains politically challenging due to entrenched distrust in state institutions, fueling public skepticism about proposals to increase revenue or reallocation funds, even when such measures are clearly necessary.
- A survey in eight ALC countries revealed that, although most respondents considered income distribution unfair, only 30% supported expanding the tax base for personal income tax.
In essence, people desire a progressive tax system but expect others to pay for it. In this environment, seeking broad political consensus on ambitious fiscal reform may result in an endless wait.
Practical and Gradual Fiscal Improvements
Governments can gain citizen trust and achieve significant progress by focusing on practical, gradual fiscal policy and management improvements. These low-profile initiatives may not make headlines but yield tangible results.
- Digitalization: Proven effective, this strategy involves digitizing tax systems and using data analytics to combat evasion.
- Targeted Subsidies: Better-directed subsidies and strengthened budget frameworks enhance fiscal efficiency, equity, and credibility, paving the way for more ambitious reforms.
- Example: El Salvador – Implementing real-time electronic billing integrated with third-party data on personal wealth and consumption increased VAT revenue from 3.5% of GDP in 2017 to 8.7% in 2023, generating $1 billion in additional revenue.
Data analytics and digital tools for directing and executing payments can make VAT more progressive without sacrificing efficiency or growth.
- Example: BID Work – Assisting governments in shifting from costly, poorly targeted VAT exemptions to direct IVA refunds for low-income households.
Solid social and fiscal records, along with well-designed delivery systems, are crucial for strengthening fiscal systems. For instance, in Uruguay, needy families use a digital payment system based on cards to reduce their VAT burden when shopping, lowering the 16% rate to 14.8%. Further improvements in targeting could reduce it by another couple of percentage points, increasing their disposable income and helping meet essential needs.
Successful Fiscal System Modernization
BID has supported efforts to modernize tax systems, resulting in significant improvements:
- Honduras – A comprehensive tax system overhaul increased the proportion of electronically declared taxpayers from 50% to 95%, boosting tax revenue by three percentage points of GDP—comparable to a painful fiscal adjustment.
- Brazil – State-level fiscal system enhancements led to an 11.7% increase in tax collection between 2012 and 2019.
BID also backed efforts to curb excessive spending:
- Chile – Digital modernization of public procurement through ChileCompra improved transparency and curbed unnecessary spending.
- Brazil – Linking electronic tax data to public procurement reference prices enabled the state government of Rio Grande do Sul to prevent overcharging and ensure better public spending.
Politically Sensitive Reforms
Even politically sensitive reforms, like subsidy reductions, can be implemented without causing social unrest. In Argentina, BID helped the government replace electricity subsidies that disproportionately benefited wealthier households with more targeted assistance, saving the country over $6 billion—nearly 1% of GDP—while protecting low-income households.
Strengthening Fiscal Institutions
Building robust fiscal institutions is essential for creating the necessary fiscal space to implement bold economic policies. BID has supported ALC governments in:
- El Salvador – Designing and implementing a new budget rule expected to reduce public debt by nine percentage points of GDP by 2030, now part of the country’s stand-by arrangement with the International Monetary Fund.
- Brazilian States – Reinforcing fiscal frameworks, doubling tax revenue from outstanding accounts between 2023 and 2024.
Adopting these practical measures can help generate confidence in economic governance. When citizens see fair tax collection and sensible spending, they are more likely to support more ambitious reforms in the future. The sooner ALC governments adopt significant measures to improve fiscal governance, modernize ineffective tax systems, and eliminate wastefulness, the sooner they can lay the groundwork for sustainable and equitable growth.
Authors
Ana María Ibáñez is Vice President of Sectors and Knowledge at the Inter-American Development Bank.
Marta Ruiz-Arranz directs the Fiscal Management Division at the Inter-American Development Bank.
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